America is in for Some Tough Times

In 1990, as a part of a mission of the European Bank for Reconstruction and Development, you participated in the drafting of proposals for a reform of the collapsing Soviet economy.  What was your opinion of the reform in Central and Eastern Europe – were you in favour of a gradualist approach, like Joseph Stiglitz, for example, or of shock therapy, such as was defended for example by Jeffrey Sachs?

I knew about certain recommendations of Jeffrey Sachs’, but I didn’t know of Stiglitz’ proposals.  Sachs was defending the opening up of the economies of Eastern Europe to western goods, their connection to western capital and loan markets.  I was certain that that in itself would not be sufficient and that a good financial structure would have to be built, that high-quality corporate governance was required, and of course, also good state economic policy.

Were you, therefore, a gradualist?

I don’t think so.  I just felt that an entire institutional foundation must be built – that that would be essential for being able to achieve good results.  Perhaps I underestimated how long it would take to build all that and for institutions to serve the way they should, without being abused or circumvented.  I undoubtedly underestimated many things, but, as I am saying, I emphasised above all, institution-building.  Until the development of the new system was entirely finished, I did not say a single word in favour of socialism.

Looking back, how do you evaluate the reform in Central and Eastern Europe, especially in the Czech Republic?

I think that the Czech Republic was one of the problem countries, primarily because its privatisation programme was not well designed.  It could have been – and should have been – prepared better.  Strong interest groups, for example certain banks, controlled companies in a decisive manner.  And it was not that western economists didn’t know about it, or that they wouldn’t have thought about it.  I remember that in 1991 to 1993, I was constantly meeting with economists, but also lawyers, who followed everything very carefully.  Their voices were probably not sufficiently strong and they were not heard.  The reform therefore did not develop well in this regard.

Should the legal framework have been prepared before privatisation was started?  Some in the Czech Republic think so, and others defend the course of privatisation: that debate is still alive.

The term legal framework today has different connotations than it used to have.  Legal framework: that could mean for example the Magna Charta.  I don’t know precisely what that term means today.  For example, according to Douglass North (Nobel Prize Laureate in Economics in 1993, note by L.K.) it is something like a small government.  It can simply mean anything you want.

By legal framework, I mean generally accepted and respected legislation.

If the legal framework expresses something, then the fact that private property can be acquired and that it will be protected.  Nobody may steal it.  Not even shareholders and/or the managers of companies can steal it.  The legal framework presumes the existence of legislation that supports various ownership rights, legal enforcement, and respect for all.  So a large problem was probably that these things were simply missing.

Some of your theories say that an excess of savings can harm the economy.  Do you agree with the claims of the Fed’s representatives that the crisis is due to the excessive thrift of economic entities in many Asian countries?  The money thus obtained was reportedly invested in the USA, which reduced interest rates, including on mortgages there, and the US central bank was unable to do anything about it.

I fundamentally do not agree with that.

For example Ben Bernanke, the head of the Fed, says that, as well.

I admire the Chinese for their thrift and modesty.  I understand that they would not be as frugal if a pension system functioned well in the country.  But it is excellent that they are saving – then world interest rates are on a low level.  That is what we have always wanted.  In the Eighties, the problem lay in high interest rates; companies in Europe were borrowing only with difficulty and in South America nearly not at all.  The Chinese came and got us out of it.  We should be thankful to them, not criticise them.

So you do not agree that low interest rates are a fundamental cause of the crisis?

It is true that rates were low for too long.  That was a mistake of the Fed.  But that is only one of the seven or ten excesses that led to the crisis.  What about those speculators who bought two, three, or four houses, thinking that the prices would only keep growing?  And what about the excesses of banks that purchased those horrendous securities “covered” by the payments of unpaid mortgages?  What about the mistakes of poorer Americans who bought houses thinking that interest rates would remain low forever?  And others…

Those committed by rating agencies?

Yes, for example.  And then of course the colossal failure of a government policy that offered everyone without discrimination that they could get their own real estate.  As if the people who didn’t have their own homes were not even American!

So instead of one excess, there were several…

It was a perfect storm of sorts.  All those phenomena simply came together at the same time.

Edmund Phelps (76)

A Professor at Columbia University in New York. He has been awarded the Nobel Prize for Economics in 2006.  He holds several prestigious awards; he is, for example, a knight of the French Honorable Legion.  As a part of a European Bank for Reconstruction and Development mission in the early Nineties, he proposed how to reform Soviet economy. Currently, he is concerned about the fluctuating American dollar and the White House’s debt. He does not, on the other hand, fear inflation or deflation.  “Just as the Fed has managed to prevent deflation, it will certainly prevent any major inflation,” he says.  The economists he most respects include Friedrich Hayek, John Maynard Keynes (but he is not fond of his “anti-business” attitudes), and Paul Samuelson (“an unbelievably refreshing thinker”).  On the other hand, he does not have much understanding for behavioural economists: he says they are only wasting time, because they are not answering fundamental questions and not addressing major problems – such as how to make the European economy more innovative.

You say that the theoretical models that economists use are also in part responsible for the crisis.  In what sense?

What I meant was that people in finance apply models that do not count on the possibility of a speculative, and therefore unsustainable, price growth that cannot be defended by reality, which must sooner or later collapse, unless some supernatural force intervenes to change everything.  Among other things, this attitude reinforced the idea that any price that is established on the market is right.  But that belief is obviously wrong.  The prices that are established on markets depend on the expectations of how the price will change in the next two or three months.  And if those expectations are incorrect, then market prices are also incorrect.  Real estate prices were strange, or one could perhaps even say that there was no support for them.  If they had any support in models, those models are as bad as the economic models used by the professionals in banking.

Do you think that a radical change in economic modelling is required?  You are for example speaking against the theory of rational expectations: does the crisis seal your reserved attitude to the theory?

Yes, I think that our present experience only underlines how unusable the idea of rational expectations is in economies whose future is unknown.  What we need are models that contend with the fact that we simply do not know the future, and that expectations are not always fulfilled.

You also say that neoclassical, textbook economics are not taking into account the authentic nature of human beings.  Do you think that after the crisis a certain paradigm shift could occur that would change this?

Excuse me, but I do not think that the problem lies in us not recognising the authentic nature of people.  It is more that those models do not recognise authentic situations in which a person finds himself.  I think that most people understand well that the future cannot be known.  Nevertheless, they want to and have to act, so they are thinking about the world and formulating their expectations.  The economists who are using those models do not understand – and that is the problem – that a good model must include the variant that the expectations with respect to the future will simply not become reality.  A good model must count on the possibility that expectations are erroneous.

You are one of the economists who were against Bush’s tax cuts.  Do you think that Obama’s administration is doing better?

Yes.  I think that it is good that Obama & Co. are not relying exclusively or predominantly on lower taxes.  Let’s not forget that another excess leading to the crisis was excessive household consumption.  Because of low interest rates, people were consuming more than they could afford.

How is this administration resolving this crisis in your opinion?

It is good that it is putting emphasis for example on infrastructure development.  That will increase employment.  As I have said, I am glad that it is not about tax reductions.  Races to reduce taxes would increase world interest rates, which would be counterproductive.  On the other hand, I think that the administration has committed gross mistakes.

What in particular?

It missed the opportunity to introduce state support for low-wage employees.  Take for example Singapore: the gross domestic product there dropped by nine percent compared to last year, but unemployment only grew from 2.2 to 3.2 percent.  And this was because they came out with support for low-income groups.  Employers were then motivated to retain those employees.  Had we done the same in the US, we could have had only a very mild recession.  And it would have only cost about two hundred billion dollars a year in total.  Instead, much more money was spent with much less effect.

Where else did the administration fail?

It is a mistake that Washington is not sending out a clearer signal that it is in favour of business and enterprise.  By that, I mean real enterprise that pursues long-term goals, not only quick profits.  And when will the financial sector be restructured?  The government is only watching Goldman Sachs cash in hefty profits from proprietary trading (trading on the bank’s own account, not with the money of clients, where the bank is creating a profit “for itself”, note by L.K.).  I don’t have anything against Goldman Sachs; it is clear that if they are making money, someone else is losing, and that they were sufficiently clever and bet on the right horse.  But proprietary trading, that is a mere waste of talent and energy.  You may just as well go to Las Vegas and try your luck in roulette.  The US economy needs long-term investments, innovation.  We must find out how to get out of debt.  How does the government want to “afford” all those social obligations, let us say, in 2020, unless the productivity of the economy grows at a really great pace?

In one of your articles, you claimed that the conditions for innovation are not as favourable in Europe as they are in America.

It has been a while since I said that.  I think that since then America has lost much of its ability to innovate, which makes me sad.  But up until some time in the early Nineties, it visibly outdistanced Europe in this regard.  Until the Eighties or the Nineties, Europe kept merely catching up with America – copying what already functioned in the US, Canada, and sometimes in the United Kingdom.

Are you not too hard on the Old Continent?

Did, let us say, France and Italy innovate in the Sixties and Seventies, when those countries grew so phenomenally?  No, they were only taking over what had been discovered elsewhere.  A problem arises with the definition of the term innovation.  What they were introducing were novelties in terms of the continent, but not from the point of view of the world.  Yes, Stockhausen’s music may have been innovative, but only a few people were fond of it (laughs).  The French New Wave also introduced some new things.  Once I was talking to a French friend of mine and I told him that his compatriots were innovators in fashion after the War, in haute couture.  He replied that that’s not true at all; all of its major representatives had already been active in the Thirties.  Perhaps he exaggerated, but when I think about it, it is unbelievable how incapable Europe is in terms of innovation.  Lars von Trier, a Danish film director, said in a recent interview that it is amazing how the emphasis on commerce in the United States allows such talented artists as Madonna or Michael Jackson to excel.  That would not happen in Europe.

Why does the US put a far greater emphasis on commerce than Europe?

But one can be entirely sound and respectable and at the same time commercially successful.  When did Mozart become really famous?  When he discovered a certain theatre in Prague where they really understood him.  That was a turning point in his career.  After all, most great composers have had an ingenious business instinct.

Even William Shakespeare was a sharp businessman.  He was one of the shareholders of The Globe theatre.

Really?  I didn’t know that.  So he wrote all those plays primarily in order to sell a lot of tickets?  That’s rather funny.

But you are saying that you do not like artists such as Madonna or Michael Jackson.

No, I do not.  But that does not mean that I do not like any commerce in culture.  I think that classical music is not characterised by being non-commercial.  All those composers wanted to have an audience. 

French President Nicolas Sarkozy proposes measuring the performance of the economy not only by the gross domestic product, but also by the “product” of the happiness and satisfaction of the population (see Economics and Happiness).  Is this not innovation?

It may be that satisfaction in life is much more based on the genetic make-up and temperament of the particular individual.  Economic policy focused on increasing it will be either absolutely nonsensical or stupid.  I am not sure which is more fitting.

What is your opinion of the presently very popular economics of happiness?  Should economic theorists study how to make people happy?

That depends on what you mean by “happiness” and “satisfaction”.  I don’t think that having satisfaction in life and having a fulfilled life are the same thing.  I don’t think that satisfaction in life or happiness are the same as personal growth.  I think that being satisfied includes doing what I want and what there is also interest in.  And then there are many things we can discuss – to what extent a society is open to new opportunities, what institutional basis it has, how it actually helps people do what they want to do.  I also think that people can be pretty happy for most of their lives without achieving what they wanted to achieve.

That there are more important goals in a human life than just being happy (for example personal growth and education) was also proclaimed by Friedrich Hayek, a key representative of the so-called Austrian School of economic thought.  What do you think about it?

The other day I heard a story that at some point someone asked Ludwig von Mises about the Austrian School and he replied: “The Austrian School?  What is that, aside from me and Hayek?!” (Laughs.)  But I think that Hayek uncovered certain important truths that were not so obvious at that time.  Mises too, to a lesser extent.  Hayek’s contribution is greater – he had the advantage of being younger than Mises, and he therefore progressed in the “second line”.  He was able to build on the basic findings in a given area that Mises had come up with, having in a way cleared the path for him.  Hayek was then able to focus on more difficult matters.  But I must say that it is the same with Keynesian economics.  Keynes’ contribution, too, is enormous.  His major work, the General Theory of Employment, Interest, and Money from 1936 is not free of errors; but overall, it is an important book.  But the next generation of economists, which appeared approximately in 1945, vulgarised and distorted Keynes’ ideas.

Whom in particular do you mean?

Economists born approximately between 1910 and 1920 – Paul Samuelson, James Tobin, and Alvin Hansen.  I think that they simplified Keynes radically and excessively.  They converted his teaching into something of which he himself was never convinced.  And Keynes was planning to write a book in the mid-Forties that would significantly differ from that from 1936, but unfortunately did not manage to do so.  I think that a similar tendency, to simplify the thought of significant figures, exists in the Austrian School, as well.  It is evident in the statements of today’s economists that everything that the government is doing – including its attempt to mitigate economic declines – is an expansive and undesirable policy.  According to them, everything that the government is doing is only making things worse.  That is unfortunate.  As I have said above, Hayek himself uncovered many fundamental truths.

You are saying that we may feel the present economic crisis for as long as fifteen years.

The crisis will be over when the gross domestic product starts growing again.  The question is what its consequences will be – what will be, let us say, the unemployment in the US in three years’ time.  I am nearly certain that it will not be lower than seven percent; rather, I am afraid that it will be between seven and eight percent.  I am also very much worried that the growth in productivity will not be sufficient and that everyone will be blaming each other for things not developing as they had imagined.  Just look at politicians: the Republicans are only thinking about tax reductions for the middle class – they are not doing much for the poorest; whereas the Democrats are, in turn, only doing what suits the unions.  It is chaos.  America is in for some tough times.

Economics and Happiness

Happiness, satisfaction, and sustainability, instead of consumption, investments, and exports – the key aspects of the gross domestic product.  French President Nicolas Sarkozy asked other countries in September 2009 to measure the performance of the economy alternatively, using new methods.  “That way, France would do much better compared to the United States, behind which it has lagged on a sustained basis in the traditional measuring of the economy,” said the Financial Times jokingly at that time.  Nevertheless, the President of France was serious; he chose Nobel Laureate Joseph Stiglitz to be the head of his team of alternative economists.

Sarkozy is not coming up with anything new.  As early as in 1972, the Kingdom of Bhutan measured not only its gross domestic product, but also the “gross product of happiness”.  Should governments and state statisticians engage in the measuring of happiness and in the subsequent “making people happy”?  Not all economists agree.  “Governments are not here to tell people what will make them happy.  They should only create conditions in which it is possible to be happy – i.e., promote democracy and decentralisation.  Furthermore, happiness is not the only thing that should be pursued – responsibility, self-improvement, and loyalty are no less important,” I was told last year by Bruno Frey, Professor of Economics at the University of Zurich, one of the few who have made a long-term study of the relationship of economics and happiness.

An abbreviated version of this interview, obtained in New York, was published in Týden No. 39 on 29 September 2009.